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Battle Inside Fed Rages Over Bank Regulation

The worst of the banking crisis may be long over, but the political contest over the Federal Reserve is entering a crucial phase in which its personality and role will almost certainly be redefined.

The Fed has tried to fend off very public efforts in Congress to strip it of responsibility for regulating America's banks, but a less-visible battle has been playing out inside the central bank. The Fed has undertaken a wrenching reorganization of its army of 3,000 bank supervisors, which has centralized more power in Washington and sometimes pitted officials at the 12 regional Fed banks against those in the capital.

Fissures at the central bank boiled over last year in a meeting in the boardroom of a Fed branch office in Memphis. The presidents of the regional banks, which dot the country from Boston to San Francisco, complained to Fed Vice Chairman Donald Kohn that the Fed's Washington bank-supervision group was adrift and not providing the district banks needed guidance on how to navigate a worsening banking crisis. Soon, though, Washington was more involved than ever. In one example: The Atlanta Fed was subjected to an especially thorough critical review of its performance as a regulator because of the large number of bank failures in the Southeast.

"The stress level of the past few years has been pretty high," says William Estes, 60 years old, who retired as head of the Atlanta Fed's bank-supervision group. The group has since been reorganized. "At a certain point you've just had enough."

Though partly a turf war, the fight over—and within—the Fed is much more than that. It is part of a broad battle over how America's financial system should be regulated, still unresolved 18 months after it stood at the brink. The ultimate outcome could shape finance as much as anything since the 1930s, when the Federal Deposit Insurance Corp. was created, or the 1990s, when banks gained freedom to cross state lines and build trading desks to compete with Wall Street.

The effort will influence how financial firms interact with the public, who decides how much risk they can take and ultimately how profitable they are. At stake, beyond that, are the Fed's effectiveness in guiding the economy toward low unemployment and low inflation, and America's ability to avoid financial crises in the future.

Before 2008, regulators and Wall Street had convinced themselves that a quarter-century of financial innovation had made the system safer by dispersing risk; responsibility was best left in the hands of banks' risk managers rather than regulators. Today, a new mind-set prevails in many quarters, including the Fed. It now is guiding commercial banks on everything from how to pay employees to how to adjust for risks in areas like commercial real estate and construction loans.

"We have been conducting intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements," Fed Chairman Ben Bernanke said last month, in a plea to lawmakers to preserve the Fed's powers. He told the Senate it would be a "grave mistake" to dilute the Fed's supervisory power, arguing that doing so would hurt the central bank's ability to steer the economy and respond to financial emergencies.

Mr. Bernanke has empowered a recent appointee to the Federal Reserve Board, Daniel Tarullo, to make the Fed a more assertive and nimble regulator. "The regulatory system did not keep up with changes in the industry and with new financial products," says Mr. Tarullo, a Georgetown law professor and former Clinton White House aide who was a critic of bank regulators before the crisis. "Our job is to go ahead, within our existing authority, with the development and implementation" of a better approach, he says.

When the U.S. created a central bank in 1913, a hotly debated compromise left power divided among Washington, New York and the other district Fed banks. Washington's authority later grew, but the district banks have continued to play a major role, especially in regulation. The Fed board of governors in Washington has given the district banks many day-to-day duties in overseeing 800 small state-chartered banks and more than 5,000 bank holding companies. Some 17,000 of the Fed's 20,000 employees work at the regional Fed banks.

Five years ago, one Fed governor sought to centralize supervision of the biggest banks in Washington. "I felt we were not being as effective as we could be," says Susan Bies, who has since left the board. "We didn't have a strong enough overall view of what was going on throughout the system." According to several people involved in the discussions, her effort was beaten back by Timothy Geithner, then president of the Fed bank in New York, which oversees some of the largest banks. Mr. Geithner, now Treasury secretary, declined to comment.

The district banks straddle an odd public-private divide. The board of each has three directors representing local commercial banks, three nonbankers chosen by banks, and three directors picked by the Fed in Washington. The boards select the district banks' presidents, in consultation with Fed headquarters. The bank influence on boards has spurred charges of a structural conflict of interest.

The president of the Fed bank in Kansas City, Thomas Hoenig, disputes that, saying the boards have no say in supervision and provide useful input on the economy. "It is important to have information from them," he said, arguing that the structure creates checks and balances that serve the nation well.

An idea still alive in the Senate Banking Committee is to hand the Fed's supervision of small banks to some other agency. Mr. Hoenig recently told Congress the result would be "further empowerment of both Washington and Wall Street in regulating financial institutions."

Camden Fine, head of a small-bank lobbying group, says shifting supervision of them from the Fed would leave the district banks "basically gutted." Worried about that threat, regional bank presidents have been personally lobbying lawmakers and speaking out for their institutions more aggressively.

Tensions were high a year ago as Fed bank presidents met in the boardroom of a Fed branch in Memphis with Mr. Kohn, the vice chairman. Mr. Hoenig and other district-bank presidents wanted clear direction on what to look for and how to proceed, especially since they had been given a large task: "stress tests" on the 19 biggest banks to gauge how well they might withstand the worst economic scenario.

The district banks' regulatory burden also had grown with the addition of institutions newly registered as bank holding companies, such as Goldman Sachs Group Inc. and Morgan Stanley. Some of the presidents say the Fed's Washington bank-supervision division became demoralized by years of scant interest in regulation from former Chairman Alan Greenspan, and told Mr. Kohn they wanted more leadership from Washington.

Mr. Kohn, who recently announced plans to retire, declined to comment. Mr. Greenspan, in an interview, acknowledged that banks should have been forced to hold more capital. He said he regretted the Fed didn't do more to stem the risky rise of "megabanks," an issue he raised in 1999. Mr. Greenspan said he shouldn't be blamed for imposing a deregulatory mind-set. As chairman, he said, he deferred to staff and other governors on regulatory matters.

Several weeks after the Memphis meeting, the Fed's director of bank supervision and regulation in Washington, 64-year-old Roger Cole, decided to leave. He says it was just time to retire, after 35 years at the Fed, including three "very difficult" ones as director. His deputy, Deborah Bailey—a strong voice on supervision, whom Mr. Bernanke had asked to lead the stress tests—also decided to go.

New governor Mr. Tarullo, who envisioned a big role for centralized government oversight, took on an assertive role.

Though the biggest banks drew the most attention during the stress tests last April and May, Fed officials also worried about large regional ones, especially in the Southeast, the scene of many bank failures. Mr. Tarullo and his team tussled with the Atlanta Fed over Regions Financial Corp., an Alabama bank with assets of $116 billion. They wanted tough assessments of the losses Regions might face if Florida real estate worsened.

Regions advised investors it was likely to see $3.4 billion in combined 2009-10 losses, and no more than $5.9 billion in the worst case. Mr. Tarullo's team told the Atlanta Fed those estimates were too low and pressed it to push harder, according to people involved in the tests. In the end, the Fed demanded Regions raise enough private capital to withstand $9 billion in possible losses. It did so.

Dennis Lockhart, president of the Atlanta Fed, wouldn't comment on Regions. He said there was normal back-and-forth, sometimes intense, among banks, Atlanta supervisors and Fed officials in Washington.

A spokesman for Regions declined to comment, but bank officials have been critical of the stress tests. "We didn't get credit for the significant de-risking that we took at the end of 2008," Chief Executive Dowd Ritter told analysts in September. He noted that the Fed's loss estimates have so far proved too pessimistic. Regions's 2009 loss was $1.03 billion.

Fed officials see the stress tests as a turning point in their efforts to stabilize the financial system, prompting the 19 largest banks to raise $140 billion in private capital. Inside the Fed, the stress tests had another effect. They gave officials a road map for strengthening Washington's hand in bank oversight, especially of the biggest institutions. Fed officials had been squabbling internally for several years about how to oversee the big banks, with Washington's push for more control resisted by regional Fed banks, especially the one in New York.

The new approach teams economists with on-the-ground supervisors to take a broader view of risks flowing through the financial system, rather than the old bank-by-bank approach led by regional Fed banks. It also involves Washington-led "horizontal reviews"—comparing findings across banks to ferret out hidden risks and assumptions that are too rosy.

Mr. Tarullo began speaking of "horizontalism" and sketching out diagrams of triangles on yellow legal pads to show how the new approach to regulation would look, say people familiar with his approach.

There was more fallout for the Atlanta Fed. Its oversight of several small banks drew criticism from the central bank's inspector general. In one case—the quick failure of a small start-up called Community Bank of West Georgia—the inspector general concluded the bank's big exposure to risky construction loans "warranted a more forceful supervisory response."

The Fed's Washington supervision office, while acknowledging the Atlanta Fed had urged the small bank to address underwriting problems, agreed with the inspector general's conclusion that more should have been done. Asked to comment, an Atlanta Fed spokesman deferred to the board in Washington.

Mr. Tarullo is pushing ahead aggressively to strengthen the Fed's bank oversight. In a move seen as a sign of change, he and Mr. Bernanke have named a senior Fed economist, Patrick Parkinson, to run the bank-supervision unit at Fed headquarters.

Many bankers and regulators still "don't fully appreciate the magnitude of what went wrong," Mr. Tarullo says. "There is this kind of instinct [in Washington] to deflect all of the blame to somebody else."